As a beginner investor, you’re most likely looking for investment avenues that offer good returns at low risk. If you’re looking to park your funds for the short-term, your top choices are either liquid funds or arbitrage funds. While liquid funds invest in debt securities, arbitrage funds invest across debt and equity and aim to generate returns through arbitrage opportunities in the cash and futures market, thus maintaining fully hedged positions. Even so, both are considered non-volatile investing modes and even offer similar returns.
The natural question then – as an investor, which one should you choose?
In this article, we review liquid and arbitrage funds and their differences. We also tell you which funds to invest in.
What are liquid funds?
Categorised as debt funds by the Securities and Exchange Board of India (SEBI), liquid funds invest in short-term market instruments like commercial papers, government securities and security bills. Although these instruments mature within 91 days, investors can redeem their returns on T+1 basis. This way, liquid funds offer higher liquidity compared to other investment avenues. Besides, the investors benefit from lower interest rate fluctuations given the lesser tenure.
What are arbitrage funds?
Categorised as hybrid funds, arbitrage funds must have 65% of the fund assets in equities or equity-related securities as per SEBI mandates. Here, the returns are generated from a pricing mismatch between purchases made in the cash market and sales made in the future’s market. For instance, an asset may have a value of Rs. 15 in market A and Rs. 20 in market B. So, if you buy the asset from market A and sell it in market B, you make a profit of Rs. 5. These are your returns.
Difference between liquid and arbitrage funds
1. Liquidity
As their name suggests, liquid funds offer better liquidity than other short-term investment avenues. Usually, the redemption amount is disbursed to the investor’s bank account on a T+1 basis or the next working day, provided the transaction is received before the cut-off time.
In contrast, redemption occurs on a T+3 basis in the case of arbitrage funds.
This makes liquid funds a preferred investment avenue for investors who want high-liquidity investments.
2. Return on investment
Since liquid funds invest in debt investment instruments that are less volatile than stocks, the returns are more stable and consistent.
In contrast, arbitrage funds invest in equity instruments that are known to offer better returns. But instead of being highly volatile like other equity instruments, arbitrage funds have almost no investment risk. This is because these investments hedge risks by buying one instrument and selling them quickly.
3. Exit Load
Most Asset Management Companies (AMCs) charge investors an exit fee when they exit or redeem the fund. That said, liquid funds are typically not associated with exit penalties unless investors redeem their funds within seven days of investing.
In the case of arbitrage funds, investors must pay fees to exit the fund. Note that these charges are applicable if the investor exits the fund within a few weeks after investing. Also, the period after which exit charges are applicable depends on the asset management company.
4. Risk
Liquid funds, being debt funds, have interest rate and credit risk. This means your returns may get affected due to a rise in interest rates if the issuer loses its financial stability.
In contrast, arbitrage funds come with no price fluctuation risk, despite being equity-oriented hybrid funds. This is because these funds are 100% hedged, given the buying and selling of assets occur quickly.
5. Tax benefits
Since the SEBI classifies liquid funds as debt funds, their returns are added to the investor’s taxable income for the financial year. Whether you invest for a short-term or long-term, you must pay taxes according to the tax slab applicable to your overall earnings in a financial year.
Arbitrage funds are taxed as equity funds. This means the STCG earned when funds are held for less than a year are taxed at 15%, whereas gains earned after holding funds for over a year are taxed under LTCG. Accordingly, if the gains are above Rs. 1 lakh, the tax is at a rate of 10%.
Arbitrage funds v/s liquid funds: Which is better?
Both investment avenues have their pros and cons. That said, opt for liquid funds if you want to invest in low-risk debt funds, want higher liquidity, and don’t want to pay an exit load on short-term investments that last a few weeks. But if you want to invest in a low-risk, high-return investment avenue, and don’t mind lower liquidity, invest in arbitrage funds.
Now, whether you’re looking to invest in liquid or arbitrage funds, you need a reliable investment partner to help you with your journey. If you’re looking for one, turn to Tata Capital Wealth. We allow customers to access their portfolio at their convenience through the Tata Capital Wealth Portal, offer relationship management services, and provide informative and qualitative reports to help you make the right investment decisions.
05 July 2023
5 mins read
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